The discount rate has an effect if banks borrow money from the Fed. This usually only happens if there is a credit crunch and financial markets are under stress, such as we went through last year. Currently, it appears that banks are on a firmer footing and there is hardly any borrowing from the Fed by banks. Therefore, the increase in the discount rate should not have any direct impact on banks or financial markets. The other interest rate that the Fed controls, the Federal Funds rate (or target rate) has a direct impact on market interest rates that you and I face, but the Fed continues to hold this rate at close to zero (0.25% at the moment).
There is however the more intangible effect of the Fed signaling that it is tightening its approach toward banks and it views the risk of financial fragility to have subsided. Also, in the past the target rate and the discount rate have tracked each other very closely. At the moment it doesn’t seem that the Fed will jeopardize the economic recovery by raising the target rate. But once it seems like the recovery is “robust”, in the sense of no longer being overly reliant on government stimulus, you can be sure the Fed will raise the target rate.
It is very important for the Fed to be able to raise interest rates when it feels confident that rate increases will not have a negative impact on the economy. This is because these interest rates are the primary tool of monetary policy in the arsenal of the Fed as far as stabilizing the economy. Unless the Fed raises its interest rates when it can, it will not be able to lower them when the next recession happens. In other words the Fed needs to raise interest rates once the economy is on a stronger footing so as to “shore up its ammunition.”
Interestingly, exchange rates went up on the day of the announcement, but fell to their previous level by the following day. We could interpret this as vindication that the discount interest rate change has had no real negative effects on the economy.
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